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# A Look At Altman's Z-Score

In 1968, a financial economist from NYU named Edward Altman developed a model for
assessing and probabilistically predicting corporate bankruptcy. The formula, known as
the Z-score model, was partly unique because it used a previously questionable
methodology: multivariate analysis. As Altman notes in his July 2000 paper revisiting
the model, the questions to ask once we accept this reasoning are as such: (1) which
ratios are most important in detecting bankruptcy potential, (2) what weights should
be attached to those selected ratios, and (3) how should the weights be objectively
established.

Rather than bogging down in the methodology (interested parties can read the paper
to the conclusion of the research, and how it set the basis for the Z-score. After
evaluating the selected companies, the model Altman developed was as such (in
Altmans original analysis, this included 66 corporations with 33 firms in each of two
group. The bankrupt (distressed) group (Group 1) is manufacturers that filed a
bankruptcy petition under Chapter X of the National Bankruptcy Act from 1946
through 1965 Group 2 consists of a paired sample of manufacturing firms chosen on
a stratified random basis.):

## Where X1 = working capital/total assets, X2 = retained earnings/total assets, X3 =

earnings before interest and taxes/total assets, X4 = market value equity/book value
of total liabilities, X5 = sales/total assets and Z = overall index; the zones of
discrimination were as such:

## Distress Zones - 1.81< Grey Zones< 2.99 - Safe Zones

The explanation (and accompanying notes from Altman) for the variables are as
follows:

X1 measure of the net liquid assets of the firm relative to the total capitalization.
Working capital is defined as the difference between current assets and current
liabilities. Liquidity and size characteristics are explicitly considered. Ordinarily, a firm
experiencing consistent operating losses will have shrinking current assets in relation
to total assets. Of the three liquidity ratios evaluated, this one proved to be the most
valuable. Two other liquidity ratios tested were the current ratio and the quick ratio.
There were found to be less helpful and subject to perverse trends for some failing
firms.

An important side note here is to watch out for inventory's impact on current assets; a
low, quick ratio and inventory with slow turn is a bad combination.

## X2 It should be noted that the retained earnings account is subject to 'manipulation'

via corporate quasi-reorganizations and stock dividend declarations. While these
occurrences are not evident in this study, it is conceivable that a bias would be
created by a substantial reorganization or stock dividend and appropriate
readjustments should be made to the accounts. The age of a firm is implicitly
considered in this ratio. For example, a relatively young firm will probably show a low
RE/TA ratio because it has not had time to build up its cumulative profits. Therefore, it
may be argued that the young firm is somewhat discriminated against in this analysis,
and its chance of being classified as bankrupt is relatively higher than that of another
older firm. But, this is precisely the situation in the real world. The incidence of failure
is much higher in a firms earlier years. In 1993, approximately 50% of all firms that
failed did so in the first five years of their existence. In addition, the RE/TA ratio
measures the leverage of a firm. Those firms with high RE, relative to TA, have
financed their assets through retention of profits and have not utilized as much debt.

The manipulation of retained earnings can generate misleading results, with the
classic example being Microsofts (MSFT) negative retained earnings due to dividend
payouts. Make sure to note when these instances appear and adjust your data
accordingly.

X3 This ratio is a measure of the true productivity of the firms assets, independent
of any tax or leverage factors. Since a firms ultimate existence is based on the
earning power of its assets, this ratio appears to be particularly appropriate for studies
dealing with corporate failure. Furthermore, insolvency in a bankrupt sense occurs
when the total liabilities exceed a fair valuation of the firms assets with value
determined by the earning power of the assets. As we will show, this ratio continually
outperforms other profitability measures, including cash flow.

From my perspective, X3 is the only stand-alone operating measure in the model, and
shows the capacity to which a firm can escape the trappings of X1, X2, and X3,
which are balance sheet items; a strong performance in X3 figures will often be how
the remaining variables are improved over time.

X4 The measure shows how much the firms assets can decline in value (measured
by market value of equity plus debt) before the liabilities exceed the assets and the
firm becomes insolvent. It appears to be a more effective predictor of bankruptcy than
a similar, more commonly used ratio; net worth/total debt (book values).

X5 This final ratio is quite important because it is the least significant ratio on an
individual basis. In fact, based on the univariate statistical significance test, it would
not have appeared at all. However, because of its unique relationship to other
variables in the model, the sales/total assets ratio ranks second in its contribution to
the overall discriminating ability of the model.

As Altman notes, Over the years many individuals have found that a more convenient
specification of the model is of the form: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +
1.0X5. The reason is due to screwy input methodology for the original model, which
could easily cause user error and result in inaccurate and useless outputs.

To date, the model has proven successful at indicating potential issues; at the time of
writing, Altman had this to say: In repeated tests up to the present (1999), the
accuracy of the Z-Score model on samples of distressed firms has been in the vicinity
of 80-90%, based on data from one financial reporting period prior to bankruptcy.
However, there is one glaring problem with the results it is suggested that the ZScore model is an accurate forecaster of failure up to two years prior to distress and
that accuracy diminishes substantially as the lead time increases.

Personally, I think the applicability of the model extends beyond the output and (as a
corollary) the zone the firm falls into. I believe that by breaking down the model into
its individual parts, you are given a picture of what is creating the financial distress at
the company (if any); when you chart the results over a couple of quarters/years, you
are also given a timeline of how the variables have transformed over time. With these
pieces in hand, you can assess how the firm must adjust their capital structure or
operating results to continue as a going concern.

Definition
Z-Score model is an accurate forecaster of failure up to two years prior to distress. It can be considered the assessment
of the distress of industrial corporations.
Columbia Pipeline Partners LP's Altman Z-Score for today is calculated with this formula:

Z = 1.2
= 1.2

* X1

+ 1.4 * X2 + 3.3 * X3

* -0.099 + 1.4 * 0

+ 0.6 * X4

## + 3.3 * 0.063 + 0.6 * 0.7848

+ 1.0 * X5
+ 1.0 * 0.1624

= 0.72
* All numbers are in millions except for per share data and ratio. All numbers are in their own currency.
Trailing Twelve Months (TTM) ended in Sep. 2014:
Total Assets was \$7,262 Mil.
Total Current Assets was \$378 Mil.
Total Current Liabilities was \$1,097 Mil.
Retained Earnings was \$0 Mil.
Pretax Income was \$419 Mil.
Interest Expense was \$-38 Mil.
Revenue was \$1,179 Mil.
Market Capitalization (Today) was \$2,638 Mil.
Total Liabilities was \$3,362 Mil.

X1

= Working Capital

/ Total Assets

## = (Total Current Assets - Total Current Liabilities)

/ Total Assets

= (378.1 - 1097.3)

/ 7261.8

= -0.099
X2

X3

X4

X5

Retained Earnings

Total Assets

7261.8

Total Assets

Total Assets

(419.3 + -37.9)

7261.8

0.063

## / Book Value of Total Liabilities

Market Capitalization

/ Total Liabilities

2638.290

/ 3361.9

0.7848
=

Revenue

Total Assets

1179.4

7261.8

0.1624

## The zones of discrimination were as such:

Distress Zones - 1.81 < Grey Zones < 2.99 - Safe Zones
Columbia Pipeline Partners LP has a Z-score of 0.72 indicating it is in Distress Zones.
Study by Altman found that companies that are in Distress Zone have more than 80% of chances of bankruptcy in two
years.

Explanation
X1: The Working Capital/Total Assets (WC/TA) ratio is a measure of the net liquid assets of the firm relative to the total
capitalization. Working capital is defined as the difference between current assets and current liabilities. Ordinarily, a firm
experiencing consistent operating losses will have shrinking current assets in relation to total assets. Altman found this
one proved to be the most valuable liquidity ratio comparing with the current ratio and the quick ratio. This is however the
least significant of the five factors.
X2: Retained Earnings/Total Assets: the RE/TA ratio measures the leverage of a firm. Retained earnings is the account
which reports the total amount of reinvested earnings and/or losses of a firm over its entire life. Those firms with high RE,
relative to TA, have financed their assets through retention of profits and have not utilized as much debt.
X3, Earnings Before Interest and Taxes/Total Assets (EBIT/TA): This ratio is a measure of the true productivity of the
firms assets, independent of any tax or leverage factors. Since a firm's ultimate existence is based on the earning

power of its assets, this ratio appears to be particularly appropriate for studies dealing with corporate failure. This ratio
continually outperforms other profitability measures, including cash flow.
X4, Market Value of Equity/Book Value of Total Liabilities (MVE/TL): The measure shows how much the firms assets
can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm
becomes insolvent.
X5, Revenue/Total Assets (S/TA): The capital-turnover ratio is a standard financial ratio illustrating the sales generating
ability of the firms assets.